McGraw-Hill, S&P sued by U.S. over pre-credit crisis ratings

McGraw-Hill Cos. and its Standard & Poor’s unit were sued by the U.S. over claims S&P knowingly understated the credit risks of bonds and derivatives that were central to the worst financial crisis since the Great Depression.

The U.S. Justice Department filed a complaint yesterday in in Los Angeles, accusing McGraw-Hill and S&P of three types of fraud, the first federal case against a ratings company for grades related to the credit crisis. McGraw-Hill tumbled the most in 25 years yesterday when it said it expected the lawsuit.

S&P issued credit ratings on more than $2.8 trillion of residential mortgage-backed securities and about $1.2 trillion of collateralized-debt obligations from September 2004 through October 2007, according to the complaint. S&P downplayed the risks on portions of the securities to gain more business from the investment banks that issued them, the U.S. said.

“It’s going to be a tricky time for rating agencies,” Fred Ponzo, a capital markets analyst at Greyspark Partners in London, said in a telephone interview. “S&P is probably just the first to face the music.”

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Under the Financial Institutions Reform, Recovery and Enforcement Act of 1989, the U.S. seeks civil penalties of as much as $1.1 million for each violation.

Settlement talks broke down after the government sought a fine of more than $1 billion and an admission of wrongdoing from S&P, the New York Times reported. That amount would wipe out the profits of McGraw-Hill for an entire year, the newspaper said.

Before the case was filed, McGraw-Hill fell 14% to $50.30 in New York trading yesterday. Moody’s Corp., owner of the second-largest ratings provider, fell 11% yesterday to $49.45. Yields on McGraw-Hill’s $400 million of bonds due November 2037 rose 31 basis points yesterday to 5.75%, the highest level since May, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Ratings firms have faced criticism from U.S. lawmakers over how they granted top grades to securities that packaged home loans from the riskiest borrowers, leading to a credit seizure, starting in 2007, that sent the world’s largest economy into its longest recession since 1933 as defaults soared and home values plummeted.

“S&P’s desire for increased revenue and market share in the RMBS and CDO ratings markets led S&P to downplay and disregard the true extent of the credit risks,” the U.S. said.

McGraw-Hill’s net income climbed 15% to $1.01 billion in 2007, only to decline more than 20% the following year.